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Credit: Anatomy of a crisis

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Joseph Mariathasan takes us on a tour of the crash and recovery, asks where bond investors should be looking next - and reminds us that credit is never, ever, a free lunch

Ben Bennett, a credit strategist at Legal and General Investment Management (LGIM), like a number of credit managers, feels pretty good about the call he made in February 2009. Near the bottom of the market he produced a note suggesting that corporate bonds offered the opportunity of a lifetime.

That has turned out to be very true, but of course that was because credit managers had all suffered through a once-in-a-lifetime dislocation in the preceding months. With hindsight, markets had crashed to unjustified levels - but perhaps it was understandable that investors had fled from all risky assets at whatever the cost.

Credit spreads in the market as a whole are still reasonably wide, says Dagmar Kent Kershaw, head of credit fund management at Intermediate Capital Group (ICG). "Rating agencies are pre- dicting that default rates will be lower than pre-crisis levels." As she points out, this is intuitively reasonable: many excessively risky credits were eradicated during the crisis. So corporate bonds as a whole still have attractive spreads over the best quality sovereigns, which in the euro-zone means Germany.

Some government bonds can also offer substantial spreads over the best quality sovereigns - Ireland and Greece have great spreads over German Bunds. But we all know why. "Their bonds are not what you would want," suggests Benno Weber, head of fixed income at Swisscanto. "With credit, you get a spread over top-rated government bonds that is more predictable. A diversified credit portfolio can now even be a better credit than a diversified government bond portfolio, whilst Germany is ridiculously expensive. We do not expect a contraction of spreads, but there is no indication that they will widen."

Average spreads may look reasonable, but benchmark index spread levels conceal an enormous variation between non-financial corporate spreads that have become very tight, and financial companies whose wide spreads reflect the huge risks still present. Betting which way spreads in the market as a whole will go when faced with two large and opposing factors - wide but risky financials and tight and expensive non-financials - may be a fool's game. Institutional investors and fund managers with a benchmark approach to bond portfolios face a very difficult set of choices. "We are seeing more disagreement on the outlook amongst our fund managers than at any other time since the crisis began," says Bennett.

What is clear is that the nature of credit investing has changed radically. "We are seeing a much more pronounced distinction today between government bond investing and credit," says Weber. "Now when our clients choose a credit manager they are much more concerned about the credit expertise the manager has and they do not want a buy and hold strategy for credit any more. They expect to see a sell discipline."

Convictions
Perhaps the significant aspect of the financial crisis for a bond manager was the test it gave them on how well they could cope with an extreme and unfamiliar environment.

"As spreads widened, managers had two options," explains Stephen Birch of Hymans Robertson. "Maintain their positions - which meant that marked-to-market positions had losses but running yield was high - or de-risk their positions by selling credits. With the benefit of hindsight, this was the severest test any manager could have had. Those who maintained their convictions came out reasonably. Those who sold credit in March 2009 will take years - if ever - to get back their performance records."

LGIM fared well, says Bennett. "Our benchmark products were correctly positioned for the crisis," he recalls. "We were underweight financials relative to the benchmarks: we had been concerned about growth trends in 2008 and then we were concerned about leverage. Banks are highly exposed to both."

But 2008, for LGIM as much as most other firms, was a time for focusing on avoiding a massive meltdown, not making money. "Downside management was key, and we devoted our resources to identifying and controlling exposures to banks, derivatives, and so on."

Credit managers like Weber, who moved to his firm in early 2009, were fortunate to have been able to benefit from the great contraction of spreads without also having to bear the pain of the great expansion that preceded it. "Before 2009, Swisscanto had many accounts that were benchmarked against government bonds although they included credit," he says.

This was easy money: credit teams with 50/50 government/credit benchmarks would simply overweight credit (say 70/30), taking credit spreads - which required no manager skill and could therefore be regarded as beta positions in credit - and effectively claiming fees for alpha. But whilst such an approach would have made it easy to beat the benchmarks in most years, like picking pennies in front of a steamroller, it generates small gains until you get crushed. The problem prior to 2007, when most products were developed, was that 2005-06 was a period of very low volatility and reduced credit spreads with a flat yield curve, so investors were seeking ways of boosting returns: no wonder so many products essentially relied on leveraging credit-spread beta. When the credit crash happened, there were massive drawdowns.

One of the lessons of the crisis has been that it is delusional to benchmark managers against a government benchmark while allowing them to invest in credit. This creates a huge mismatch between the risks investors expect and the risk they are actually getting from their portfolios. It was certainly a lesson drawn by Swisscanto: "We moved to a 100% credit benchmark in 2009 after I arrived," says Weber. For him, the timing was perfect - although by switching benchmarks Swisscanto effectively locked in the underperformance seen in 2008. Like many credit managers, the firm saw strong inflows into corporate bond products from early 2009 to the end of 2010.

During most of 2009, the primary credit markets were trading at a substantial premium in yields to the secondary markets. The secondary market was very illiquid as the banks had reduced their balance sheets and as a result, the dealers had little inventory. Firms with cash inflows had a tremendous opportunity to arbitrage primary and secondary market valuations.

"We managed to get a couple of primary deals that we flipped at a profit into the secondary market after a couple of weeks," says Weber, "although typically we don't like doing that, since if the investment banking syndicates see you selling after two weeks they will reduce future allocations to you."

The big carry in the primary market disappeared towards the end of 2009 and whilst that year had enabled investors to benefit from huge spread contraction even in the highest rated credits, 2010 was the year that managers such as Swisscanto moved down the credit spectrum. "We are allowed to have up to 10% in non-investment grade credits," says Weber. "Usually we keep it at 2%, which is really there as a parachute for falling investment grade credits, but we currently have 7-8% in high yield, which is attractive for the carry, although we do expect to reduce it by the end of the year."

Defaults
ICG took advantage of this unprecedented mar- ket environment by launching a recovery fund in 2009, initially buying loans. "We were buyers throughout most of 2009," says Kent Kershaw. "Towards the end of that year, a large amount of the bounce back had already occurred in loans and we started to see the high yield market re-open with some very attractive issuance."

ICG launched a European high yield fund initially with investment from its own balance sheet, and subsequently opened this out to third-party investors, capitalising on the fact that its expertise in both loans and high yield gave it insights into which loans were likely to be refinanced in the high yield market.

High yield, of course, saw the most dramatic falls during the crisis and also the most dramatic recoveries. Today, the market is starting to recognise that there may be more risk in duration than credit.

"High yield companies are, on average, more creditworthy than they have been for years," says George Muzinich, CEO of Muzinich & Co. "Balance sheets are at historically strong levels. Default rates are running below 2%, considerably below historic median levels. The market, however, continues to price default risk at past levels of over 4%."

Kent Kershaw concurs: "People are comparing credit spreads with the depths of the crisis but then, default rates were 16%. Spreads in high yield have come in by 1,000 basis points, but if you exclude the crisis years, spreads still look pretty attractive on a historical basis." She argues it will take the market some time of new issuance from less creditworthy companies before we see the higher default levels that we are used to from history. Sure enough, private equity sponsored debt issuance is coming back with leverage multiples modestly creeping up. "In the US, the market has become very aggressive much more quickly than in Europe, with the return of dividend recapitalisations and ‘covenant-lie' loans," she says. "In Europe the market was always less volatile than the US so structures were less aggressive and defaults lower. Europe is certainly lagging the US in its current repricing of risk."

Relative to the US and Europe, Asian investors are very sensitive to credit risk - although developed world financial markets were at the epicentre of the financial crash and, as Brian Baker, CEO of PIMCO Asia, explains, it had little direct effect on Asian institutions. Central banks, insurance companies and others had little exposure to the US housing market through sub-prime securitised debt, unlike institutional investors in Europe. They were still keen to understand the effects of that crisis on all assets on their balance sheets, and when it came, they had to rein in risk.

Whilst central banks in particular remain wary of credit products, there is demand elsewhere for Asian corporate debt. Issuance was around $65bn (€46bn) in 2010 and is likely to hit $70-80bn or more in 2011, according to Neeraj Seth, head of Asian credit for BlackRock. High yield would account for around one third of that, and could go higher with the demand for hybrid securities: "The major high yield issuers are from China, followed by Indonesia," he says. "The investors vary, with US and Asian investors interested in Indonesian natural resources, whilst if it is Chinese real estate, it would tend to have interest only in Asia."

Absolute
So where should bond investors turn now? Inflationary pressures in emerging markets and the imminent cessation of quantitative easing are factors that investors worry will push bond yields higher. Retail investors have taken this to heart, with LGIM's absolute return bond fund seeing very large cash inflows in the past couple of years.

"If you are incredibly bullish on the global economy and believe that there will be a consumer-led boom - and there is some data suggesting that - then rate products are not attractive," says Bennett. "You should be in equities. [Flows into our absolute return products] have been driven by a combination of people getting more comfortable with risk in the second half of 2009, and people worrying about bond yields from the second half of 2010. If you are a bond investor following a benchmark, even if the fund outperforms the benchmark, a rising rate environment will mean that the total return will not be good."

But pension funds matching liabilities may have no choice on duration, so credit exposures are the only way of outperforming their liability driven benchmarks. Fund managers are constrained by their mandates as to how much duration risk they can take against the benchmark. Bennett says LGIM's core benchmark portfolios, for example, take very little duration risk relative to the benchmark, focusing just on credit risk.
Institutional investors looking at credit as a source of absolute returns do not need to constrain their fund managers to a bond benchmark. But absolute return strategies have a chequered history. They started achieving prominence from around 2004, driven by a number of factors, such as the introduction of UCITS III. Many US firms in particular prided themselves on their large credit research teams, built up to manage investments in the large US corporate credit and asset-backed securities markets. The advent of absolute return strategies enabled them to transport this expertise to strategies aimed at beating non-US benchmarks through combinations of swaps and absolute return bond funds. Sophisticated managers realised that they had the building blocks to deliver LDI: they could match the liabilities with swaps, so they just had to generate the floating rate leg tied to LIBOR.

These products ended up encompassing a huge range of strategies with very different risks, returns and liquidity profiles, making them difficult to compare with one another. What they did purport to do was package many of the techniques used by hedge fund managers into a framework suitable for European institutional and retail investors - and their growth looked set to continue at a very high rate until the credit crisis - when they failed miserably, as a class, to deliver on their promises. The underlying cause was of course credit and the fact that many strategies turned out to be nothing more than leveraged positions on credit spreads.

"The biggest upset in 2008 was in any strategy that was based on carry - such as incremental gains on coupons on credit," says Birch at Hymans. "This applied right across the board to investment grade, high yield, ABS and MBS and emerging market debt - anything that was yielding more than a government bond or cash. The issue that was brought to the fore was that credit managers had been overweight credit at the wrong time - when investment grade was yielding less than 1% over government bonds. The temptation had been for absolute return bond managers to have a lot of credit when, universally, credit was very expensive."

Clearly, lessons have been learnt on both the strengths and the weaknesses of different approaches to absolute return bond funds. In particular, in the new generation of absolute return bond products that are appearing, there will be more of a separation between those strategies that use credit and those that do not.

Asymmetric
The asymmetric nature of returns on bonds and of credit exposures cannot be ignored. Unfortunately, it often is: managers are deemed to have good risk-adjusted performance if they can have a steady return with a low level of volatility. But negative returns tend to be larger than positive returns: in bonds, you can lose all of an investment, but the upside is forever limited to the coupons and return of principal. Managers were feted before the crisis for their ability to produce steady outperformance, despite the fact that credit spreads are not normally distributed and, once in a while, they blow up.

Managers can charge more fees for products that claim to produce alpha rather than beta. With credit, it can be difficult to differentiate between the two. There will always be a temptation by fund managers to achieve more running yield through investing in riskier credits. Bond indices may be able to add value to the process by constraining the universe a manager is allowed to invest in, as well as acting as a performance comparison. But the benchmarks themselves may be riskier in absolute terms than a fund manager's portfolio (which may have less weighting in financials, for example). So risk measured against a bond index is not a measure of absolute risk.

As spreads become tighter, there are two ways to enhance return: going further down the risk spectrum, or leveraging the return available on less risky credits. Managers have already gone down the risk spectrum in many cases, whilst products coming out on the market under the guise of ‘risk parity' have been predicated on essentially having high exposures to bonds and leveraging the exposures.

What the crisis showed is that investing in credit is not a free lunch. Ongoing pick-ups in yield over risk-free assets come at a cost. As long as their clients really understand what the cost may be, fund managers are at liberty to utilise their skills in the credit markets to produce competitive products. But in the current credit environment, investors have to be confident that the products will do what is claimed for them if another crisis comes.
 

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